When Warren Buffett makes an acquisition on behalf of Berkshire Hathaway, it immediately triggers a hindsight bias reaction that makes you think–oh yes, it was so obvious, how did I not see that coming? The latest news report, covered by the Wall Street Journal, indicates that Warren Buffett is expected to complete the purchase of Precision Castparts for somewhere in the neighborhood of $37 billion.
Some of the commentary about the deal conveyed befuddlement as to why Buffett would be interested in a stock that fell from $275 per share in 2014 to $190 in 2015, and subsequently indicated that Buffett is paying too much by valuing the company in the range of $230 per share. As you can already guess, I regard that commentary as typically short-sighted and ignorant of Precision Castparts’ unusually strong balance sheet and unusually strong earnings per share growth for an industrial.
I always wonder–what will be Buffett’s signature investment when you tally up the biggest investment victories of his life? There are a lot of candidates that come to mind. A young Warren Buffett made a lot of money quickly by owning concentrated positions in GEICO and American Express at times they were disfavored.
The American Express investment is especially impressive when considered in the light of its context–Buffett’s father passing away, President Kennedy getting shot, the salad oil measurement fraud tainting the brand. Keeping your head straight and allocating millions of dollars while you are enduring personal strife, the country is in mourning, and the chosen company is especially tainted gives the American Express investment some added legacy value beyond a strict numerical calculation of the wealth created by the investment. It was also at a time in Buffett’s life when added wealth carried more personal utility–going from $2 million to $8 million can change your lifestyle more than $150 million to $600 million.
Other candidates that come to mind include The Washington Post investment which Buffett eventually parlayed into ownership of Graham Holdings’ cable assets, plus he gained the politically valuable relationship with Kay Graham that introduced him to business leaders and DC politicians.
When he eventually made investments in companies like Coca-Cola (another candidate for the greatest legacy investment), he was able to transition onto the Board of Directors and influence decision-making much quicker than if the relationships had to build organically without the Graham connection. Buffett was able to stop Douglas Daft from spending $16 billion to purchase Quaker Oats so Coca-Cola could get its hands on Gatorade. Buffett convinced the board it was too expensive, and the deal didn’t go through, marking Buffett’s first example of super high-profile influence post-Salomon.
After making the Heinz acquisition, and then turning that into Kraft-Heinz, I mentioned that Berkshire Hathaway has the infrastructure in place to perpetually execute bigger and bigger deals.
When you don’t pay a dividend, and have between $1 billion and $2 billion rolling into Omaha headquarters every month, you are going to have the opportunity to make some interesting deals. This has especially been the case as Berkshire’s cash hoard swelled above $50 billion prior to the announcement of the Precision Castparts acquisition.
This $37 billion could be Buffett’s legacy because it adds some significant cement to Berkshire’s transition from an investment company to an operating company. Some analysts panned the deal, but I think Precision Castparts is a company of beauty. It makes $2 billion in annual profits, and only carries $4.5 billion in total debt. Usually, industrials carry four or five times annual earnings in debt, and the amount of debt on the Precision balance sheet could be characterized as “moderate to light.” It also has almost $500 million in cash.
Fifteen years, Precision wasn’t even making $100 million per year. Profits have increased twenty-fold in fifteen years. When you have 31% operating margins, you can achieve growth like that. Earnings per share growth has been in the 22% range since 2000, and shareholders have turned $50,000 into $1,000,000 over the past fifteen years. Top-line revenue growth has been 14.5% of this time frame.
Precision makes the metal components that go inside the Airbus A350 and the Boeing 787, and has also been a growing player in the business of providing metals that go into the production of turbine engines in the wind, oil, and gas industries. When you see blue-collar guys who never earned more than $75,000 leave behind seven-figure estates, you frequently see large ownership positions in nuts-and-bolts companies like General Electric, Honeywell, Illinois Tool Works, Emerson Electric, and Precision Castparts comprise their fortune.
It seems that people who work with their hands know the value of the indispensable parts sold by these companies. Just as someone who owns a Dairy Queen franchise would know that no Blizzard is complete without going through Mar’s Candy or Hershey, these types of investors know that you can’t build anything without nuts and bolts and these companies possess characteristics that bend with technology rather than get displaced by technology.
I think this is going to be a huge home-run deal for Buffett and Berkshire shareholders. It is not often that you stumble across a billion-dollar industrial company with earnings growth north of 10%. By my estimation, Berkshire generates $20 billion in profit per year. This $2 billion in net profits should increase earnings per share at Berkshire by 10% once the company is fully absorbed.
And yet, the price of the stock is still essentially unchanged since the announcement of the deal, sitting at $141 per share. My guess is that Berkshire will trade in the $160s or $170s once there are a few reporting quarters that include the contributions of Precision Castparts because the higher earnings ought to drag the price of the stock forward.
Buffett expects to be quiet for a year or two following this deal, as it will tack on $10 billion in debt and knock Berkshire’s cash hoard down to the $30 billion range. He mentions that, for purposes of being able to take advantage of a drastic stock market correction or unusually high insurance catastrophe, he likes to keep $20 billion in cash on hand at all times. When you add the $10 billion in debt to the new $30 billion cash hoard, you are looking at a surplus of about $20 billion.
The acquisition button has been reset to zero, and the Omaha conglomerate will be adding about $2 billion in cash per month as it replenishes its reserves.
It is funny to me, though, that people always act like the ship has sailed with high-quality companies. If you go through the archives on The Motley Fool in 1998 or 1999, you will find articles discussing the quality of Coca-Cola stock. It was talked about as the perfect investment. People objected that Coca-Cola had a great past, but there was no guarantee it would continue to have a great future. They thought that particular investment ship had sailed and left them behind, and they needed to go find a different investment.
Well, Coca-Cola made $0.70 per share in profits in 1998, and made $2.04 in 2014. Profits almost tripled in sixteen years. The story isn’t over because the per unit profits are high, and the company has pricing power to raise prices by amounts greater than inflation each year and it also has retained earnings to make acquisitions that get neatly folded into its beverage distribution system.
Now, Coca-Cola wasn’t a good buy in 1998 or 1999 because it traded at 50x earnings, so a valuation objection was merited. But an objection on the grounds that the growth story was over has not proven accurate.
Something similar is happening with Berkshire right now. People see that Buffett is 85, and assume that Berkshire won’t be a great 20+ year hold. What they don’t see is that Buffett has spent the twilight of his life turning Berkshire into an operating company that has many independently run and managed profitable lines that throw off copious amounts of cash on behalf of shareholders.
The story isn’t over yet, and $140 per share is a very fair price for Berkshire. I started covering the company a few years ago–maybe it was 2011 or 2012?–and I remember the stock trading in the $70 range when I first started discussing it. Then, like now, there were concerns that its days of meaningful growth were behind it. But yet, Berkshire has grown profits from $10 billion in 2011 to $21 billion expected for 2015. It wasn’t valuation changing that propelled returns–it was Berkshire churning out more and more cash.
And yet, here we are again. Buffett made another masterstroke that will add 10% to Berkshire’s immediate earnings, plus shareholders will benefit from the growth in the existing businesses and the fast growth at Precision to add some velocity to the $1-$2 billion that Buffett is currently receiving monthly at Berkshire. The story will continue to repeat itself when Buffett has the cash on hand to make another $20+ billion deal in another year or two. The obvious companies with great track records have the platforms for perpetual success going forward, but also get perpetually ignored by people that think the ship has passed them by.